Retirement plans at work are among the most common investment bridges that United States citizens use to save for retirement, as of December 31, 2022, there were approximately $26 trillion in retirement plans sponsored by employers, including traditional pension, profit-sharing, and 401(k) plans.
It’s critical to understand your 401(k) plan as you plan your retirement journey, let’s learn the differences between pre-tax contributions and Roth 401(k) contributions, so you can better understand your 401(k) contribution options. your retirement plan.
The Basics: Contributing to Your 401(k) Plan
A 401(k) plan is an employer-sponsored retirement plan that allows workers to save for their tax-advantaged retirement. When you enroll in a 401(k) plan, you agree to have a percentage of your salary allocated to the plan’s investment accounts.
You can contribute up to $23,000 in 2024, up from $22,500 in 2023. People age 50 or older at the end of the calendar year can make annual catch-up contributions, up to $7,500 in 2024, depending on your 401 plan. (k), your employer may match a certain percentage of your contributions.
When choosing how to contribute to your 401(k) plan, you can typically choose between:
“A pre-tax contribution, “which contributes a portion of your compensation to your retirement plan account before applying state, federal or local taxes and withholdings.” “A Roth contribution, which contributes a portion of your compensation to your retirement plan account after applying state, federal and local taxes.”
Not all 401(k) plans provide a Roth feature; You will need to inquire about your employer’s plan to see if they are allowed, however, since 90% of 401(k) plans now provide Roth options, employees should understand the difference and impact each has of these options.
The Difference in Pre-tax Contributions vs. Roth 401(k)
What Is a Pre-tax 401(K) Contribution?
Pre-tax 401(k) contributions are contributions taken before taxes are taken out of your paycheck, so you have the tax advantage for the year you contribute.
An example that illustrates this:
A citizen’s monthly taxable income is $5,000, let’s assume his tax rate is 22%, further suppose the taxpayer would like to contribute 10% of his pre-tax income to his 401(k) account before taxes.
This would be the result:
- $5,000 x .10 = $500 (401(k) contribution before taxes)
- $5,000 – $500 = $4,500 (remaining income before taxes)
- $4,500 x .22 = $990 (tax owed)
Not only can the citizen contribute $500 before taxes to their 401(k) account, but the deferrals they make also decrease their taxable income for the year.
What Is a Roth Contribution?
Roth contributions are contributions made from your income after federal, state, and local taxes have already been withheld, so there are no tax advantages for the year you contribute, like a pre-tax contribution.
For example, using the same facts we did above with the Roth contribution:
Taxpayer’s monthly taxable income is $5,000, let’s assume his tax rate is 22%, let’s further assume that this citizen would like to contribute 10% of his after-tax income to his Roth 401(k) account.
This would be the result:
- $5,000 x .22 = $1,100 (tax owed)
- $5,000 x .10 = $500 (Roth 401(k) contribution)
- $5,000 – $1,100 – $500 = $3,400 (income after taxes and contributions)
